Fundamentals of

Corporate Finance, 3/e

Robert Parrino, Ph.D.
David S. Kidwell, Ph.D.
Thomas W. Bates, Ph.D.

Chapter 13: The Cost of Capital

Copyright 2015 John Wiley & Sons, Inc.

Learning Objectives
1. Explain what the weighted average cost of capital

for a firm is and why it is often used as a discount

rate to evaluate projects
2. Calculate the cost of debt for a firm
3. Calculate the cost of common stock and the cost of
preferred stock for a firm

Copyright 2015 John Wiley & Sons, Inc.

Learning Objectives
4. Calculate the weighted average cost of capital for a

firm, explain the limitations of using a firms

weighted average cost of capital as the discount rate
when evaluating a project, and discuss the
alternatives to the firms weighted average cost of
capital

Copyright 2015 John Wiley & Sons, Inc.

The Firms Overall Cost of Capital

Since unique risk can be eliminated by holding a diversified

portfolio, systematic risk is the only risk that investors require

compensation for bearing.
We concluded in Chapter 7 that we could rely on the CAPM to
arrive at the expected rate of return for a particular investment.
In this chapter, we address the practical concerns that can make
that concept difficult to implement.

Copyright 2015 John Wiley & Sons, Inc.

The Firms Overall Cost of Capital

Firms do not issue publicly traded shares for individual projects
As a result, firms have no way to directly estimate the discount rate that
reflects the risk of the incremental cash flows from a particular project
Financial managers deal with this problem by estimating the

cost of capital for the firm as a whole and then requiring

analysts within the firm to use this cost of capital to discount
the cash flows for all projects
A problem with this approach is that it ignores the fact that a firm is really

a collection of projects with varying levels of risk

Copyright 2015 John Wiley & Sons, Inc.

The Finance Balance Sheet

Accounting Balance Sheets reflect book values
Left-hand side: book value of the firms assets, based on historical costs
Right-hand side: how those assets were financed
Finance Balance Sheets reflect market values
Left-hand side: total market value of assets, the present value of total cash

flows that those assets are expected to generate in the future

Values of the claims that investors hold must equal the value of the cash
flows that they have a right to receive
Total market value of the debt and the equity of a firm is the present value
of the cash flows that the debt holders and the stockholders have the right
to receive

Copyright 2015 John Wiley & Sons, Inc.

Market Value of Assets

The Finance Balance Sheet
Equation 13.1

Copyright 2015 John Wiley & Sons, Inc.

Copyright 2015 John Wiley & Sons, Inc.

Estimating Cost of Capital

If analysts at a firm could estimate the betas for each of the

firms individual projects, they could estimate the beta for the
entire firm as a weighted average of the betas for the individual
projects
Analysts must use their knowledge of the finance balance sheet,
along with the concept of market efficiency, to estimate the cost
of capital for the firm
Rather than performing calculations for the individual projects

represented on the left-hand side of the finance balance sheet,

analysts perform a similar set of calculations for the different types
of financing (debt and equity) on the right-hand side of the finance
balance sheet

Copyright 2015 John Wiley & Sons, Inc.

Cost of Capital
As long as they can estimate the cost of each type of financing

by observing that cost in the capital markets, they can compute

the cost of capital for the firm by using the following equation:
Equation 13.2

Copyright 2015 John Wiley & Sons, Inc.

Estimating the Cost of Capital

If we divide the costs of capital into debt and equity portions of

the firm, then we can use the above to arrive at the weighted
average cost of capital (WACC) for the firm:

Copyright 2015 John Wiley & Sons, Inc.

Example: Weighted-Average Cost of Capital

The total value of a firm is $4,000,000 and it has $300,000 debt.

The cost of debt is 6% and the cost of equity is 10%. What is the
weighted-average cost of capital (WACC)?

Copyright 2015 John Wiley & Sons, Inc.

Estimating the Cost of Debt

Analysts often cannot directly observe the rate of return that

investors require for a particular type of financing and instead

must rely on observed security prices to estimate the required
rate
With regard to the cost associated with each type of debt that a
firm uses when we estimate the cost of capital for a firm, we are
particularly interested in the cost of the firms long-term debt
Long-term debt refers to debt borrowing set to mature in more than one

year
Debt with a maturity of more than one year can typically be viewed as
permanent debt because firms often borrow the money to pay off this debt
when it matures

Copyright 2015 John Wiley & Sons, Inc.

Estimating the Cost of Debt

Interest rate (or historical interest rate determined when the debt

was issued) that the firm is paying on its outstanding debt does
not necessarily reflect its current cost of debt
Current cost of long-term debt is the appropriate cost of debt for
WACC calculations
WACC is the opportunity cost of capital for the firms investors as of

today

Use yield to maturity (YTM) for cost of debt, adjusting for the

tax deductibility of interest on debt

Copyright 2015 John Wiley & Sons, Inc.

Taxes and the Cost of Debt

The after-tax cost of interest payments equals the pre-tax cost

times 1 minus the tax rate:

Equation 13.3

Copyright 2015 John Wiley & Sons, Inc.

Example: Cost of Debt

The before-tax cost of debt for a firm is 6% and the marginal tax

rate is 20%. What is the after-tax cost of debt for the firm?

Copyright 2015 John Wiley & Sons, Inc.

Estimating the Cost of Debt

The current cost of debt for a publicly traded bond is derived

from its yield to maturity calculation

Consider compounding periods, the effective annual interest rate (EAR),

and the cost of issuing the bond (float costs)

For private debt, a firm can ask their bank and ask what rate the

bank would charge if they decided to refinance the debt today

To estimate the firms overall cost of debt when it has several

debt issues outstanding, we must first estimate the costs of the

individual debt issues then calculate a weighted average of
these costs
Copyright 2015 John Wiley & Sons, Inc.

The Cost of Equity: Common Stock

Just as information about market rates of return is used to

estimate the cost of debt, market information is also used to

estimate the cost of equity
There are several ways to do this and the most appropriate will
depend on what information is available and how reliable the
analyst believes it is
The text discusses three alternative methods for estimating the
cost of common stock
Method 1: Using the Capital Asset Pricing Model (CAPM)
Method 2: Using the Constant-Growth Dividend Model
Method 3: Using a Multistage-Growth Dividend Model

Copyright 2015 John Wiley & Sons, Inc.

Capital Asset Pricing Model (CAPM)

The first method for estimating the cost of common equity is

the CAPM method:

Equation 13.4

Copyright 2015 John Wiley & Sons, Inc.

Capital Asset Pricing Model (CAPM)

There are some practical considerations that must be considered

when choosing the appropriate risk-free rate, beta, and marketrisk premium for the above calculation
The recommended risk-free rate to use is the risk-free rate on a
long-term Treasury security because the equity claim is a longterm claim on the firms cash flows
A long-term risk-free rate better reflects long-term inflation expectations

and the cost of getting investors to part with their money for a long period
of time than a short-term rate

Copyright 2015 John Wiley & Sons, Inc.

Capital Asset Pricing Model (CAPM)

One can estimate the Beta for that stock using a regression

analysis
Identifying the appropriate beta is much more complicated if
the common stock is not publicly traded
This problem may be overcome by identifying a comparable company

with publicly traded stock that is in the same business and that has a
similar amount of debt
When a good comparable company cannot be identified, it is sometimes
possible to use an average of the betas for the public firms in the same
industry

Copyright 2015 John Wiley & Sons, Inc.

Capital Asset Pricing Model (CAPM)

It is not possible to directly observe the market risk premium

since we dont know what rate of return investors expect for the
market portfolio
For this reason, financial analysts generally use a measure of
the average risk premium investors have actually earned in the
past as an indication of the risk premium they might require
today
From 1926 through the end of 2012, actual returns on the U.S. stock

market exceeded actual returns on long-term U.S. government bonds

by an average of 5.71% per year
If a financial analyst believes that the market-risk premium in the past
is a reasonable estimate of the risk premium today, then he or she might
use 5.71% (or a value close to it) as the market risk premium for the
future
Copyright 2015 John Wiley & Sons, Inc.

Constant-Growth Dividend Model

In the second method to estimate the cost of equity we use the

constant growth valuation model we discussed in Chapter 9:

We can rearrange this equation to solve for the required rate of

return:
Equation 13.5

Copyright 2015 John Wiley & Sons, Inc.

Constant-Growth Dividend Model

In order to solve for the cost of common stock, we must

estimate the dividend that stockholders will receive next period,

D1, as well as the rate at which the market expects dividends to
grow over the long run, g
This approach is useful for a firm that pays dividends that will

grow at a constant rate, which is appropriate for an electric

utility but not for a fast growing high-tech firm

Copyright 2015 John Wiley & Sons, Inc.

Multistage-Growth Dividend Model

The third approach is based upon the supernormal-growth

dividend model discussed in Chapter 9

The complexity of this approach lies in choosing the correct
number of stages of forecasted growth as well as how long each
stage will last
Because of the algebraic complexity in solving for the required
rate of return, the value is generally solved for using a trial and
error method, after forecasting the different stages of dividend
growth

Copyright 2015 John Wiley & Sons, Inc.

Copyright 2015 John Wiley & Sons, Inc.

Copyright 2015 John Wiley & Sons, Inc.

Common Stock
Which method should we use?
In practice, most people use the CAPM (Method 1) to estimate the cost of
equity if the result is going to be used in the discount rate for evaluating a
project

Copyright 2015 John Wiley & Sons, Inc.

The Cost of Preferred Stock

The characteristics of preferred stock allow us to use the

perpetuity model (Eqn. 6.3) to estimate the cost of preferred

equity
Just as with common stock, we can find the cost of preferred
equity by rearranging the pricing equation for preferred shares:
Equation 13.6

Copyright 2015 John Wiley & Sons, Inc.

Example: Cost of Preferred Stock

A share of preferred stock has a 5% dividend rate, $100 stated

value, and a price of $85. What is the cost of this preferred

stock?

Copyright 2015 John Wiley & Sons, Inc.

Weighted-Average Cost of Capital

The after-tax version of the formula for the weighted-average

cost of capital is:

Equation 13.7

It should be noted that the financial analyst should use market

values rather than book values to calculate WACC

Copyright 2015 John Wiley & Sons, Inc.

Using the WACC in Practice

Limitations of WACC as a discount rate for evaluating projects
Financial theory tells us that the rate that should be used to discount these
incremental cash flows is the rate that reflects their systematic risk
This means that the WACC is going to be the appropriate discount rate for
evaluating a project only when the project has cash flows with systematic
risks that are exactly the same as those for the firm as a whole

Copyright 2015 John Wiley & Sons, Inc.

Using the WACC in Practice

Limitations of WACC as a discount rate for evaluating projects
When a single rate, such as the WACC, is used to discount cash flows for
projects with varying levels of risk, the discount rate will be too low in
some cases and too high in others
When the discount rate is too low, the firm runs the risk of accepting a negative

NPV project estimated NPV will be positive even though the true NPV is
negative
When the discount rate is too high, the firm runs the risk of rejecting a positive
NPV project estimated NPV will be negative even though the true NPV is
positive
The key point is that it is only really correct to use a firms WACC to discount
the cash flows for a project if the following conditions hold

Copyright 2015 John Wiley & Sons, Inc.

Using the WACC in Practice

Limitations of WACC as a discount rate for evaluating projects
CONDITION 1: a firms WACC should be used to evaluate the cash

flows for a new project only if the level of systematic risk for that project
is the same as that of the portfolio of projects that currently comprise the
firm
CONDITION 2: a firms WACC should be used to evaluate a project only

if that project uses the same financing mix the same proportions of debt,
preferred shares, and common shares used to finance the firm as a
whole

Copyright 2015 John Wiley & Sons, Inc.

Copyright 2015 John Wiley & Sons, Inc.

Alternatives to WACC
If the discount rate for a project cannot be estimated directly, a

financial analyst might try to find a public firm that is in a

business that is similar to the project
This public company would be what financial analysts call a pure-play

comparable because it is exactly like the project

This approach is generally not feasible due to the difficulty of finding a
public firm that is only in the business represented by the project

Financial managers sometimes classify projects into categories

based on their systematic risks

They then specify a discount rate that is to be used to discount the cash

flows for all projects within each category

Copyright 2015 John Wiley & Sons, Inc.

Copyright 2015 John Wiley & Sons, Inc.